Simple Monetary Rules Under Fiscal Dominance

Is aggressive monetary policy response to inflation feasible in countries that suffer from fiscal dominance? We find that if nominal interest rates are allowed to respond to government debt, even aggressive rules that satisfy the Taylor principle can produce unique equilibria. However, resulting inflation is extremely volatile and zero lower bound on nominal interest rates is frequently violated. Within the set of feasible rules the optimal response to inflation is highly negative, and more aggressive inflation fighting is inferior from a welfare point of view. The welfare gain from responding to fiscal variables is minimal compared to the gain from eliminating fiscal dominance.Interest rates;Government expenditures;inflation, monetary policy, inflation targeting, monetary authority, nominal interest rates, central bank, real interest rate, price stability, coefficient on inflation, price level, monetary economics, aggregate demand, nominal interest rate, real interest rates, high inflation, monetary fund, inflation response, inflation objective, money demand, real value, expectations of inflation, monetary policies, monetary response, control of inflation, foreign currency, money balances, optimal monetary policy, rate of inflation, real money, lower inflation, real variables, increase in inflation, inflation targeting regime